Question

You are a portfolio manager meeting a client. During the conversation that follows your formal review of her account, your client asks the following question:

My grandson, who is studying investments, tells me that one of the best ways to make money in the stock market is to buy the stocks of small-capitalization firms late in December and to sell the stocks one month later. What is he talking about?

a. Identify the apparent market anomalies that would justify the proposed strategy.

b. Explain why you believe such a strategy might or might not work in the future.

Short answer

The correct answer is:

a. recommends taking advantage of small firm anomaly and the January anomaly.

b. strategies might not work because (i) similar attributes would pose more risk (ii) no assurance of same yields in future and (iii) Investment decisions might nullify the relationship after making the results of the studies publically known.

Step-by-step solution

Definition

Usually shares of smaller companies ranging between $250 million to $2 billion are known as small capitalization or small cap firms.

Explanation

a. In the above scenario, the grandson recommends taking advantage of:

(i) the small firm anomaly

(ii) the January anomaly and

(iii) the small-firm-in January anomaly.

b. For the following reasons, the strategy might not work:

i) Having same or similar attribute portfolio in stocks may expose the portfolio to more risk. There is also a limited potential for diversification.

(ii) Even if the study results are correct there is no assurance that future time periods would yield similar results.

(iii) After the results of the studies became publicly known, investment decisions

might nullify these relationships.